Managers selective on EM in event of Fed policy mistake

Instead of investing in the whole complex, managers prefer emerging economies with a strong balance sheet

Emerging markets
Emerging strength: Argentina, India, Indonesia and Mexico are favourites as they tend to perform relatively strongly in difficult environments

Money managers are eyeing emerging markets (EM) with stronger balance sheets as they could be less reactive to a potential policy mistake by the Federal Reserve, and also better suited to playing the growth differential story that exists with their more developed peers.

Gordian Kemen, a global head of emerging markets fixed-income strategy at Morgan Stanley, who spoke on the emerging markets panel at the 14th annual FX Week USA conference on July 12, said he expects emerging markets growth to outpace that of developed markets (DM) because the spurt is broad-based.

“It is not just happening in one or two countries. That was the description for last year; we had Brazil and we had Russia coming out of recession. We are now seeing it broad-based, synchronised with DM,” Kemen said. “So my view is that if the Fed commits a policy mistake, obviously it is going to send out some ripple effects and obviously [foreign exchange] is more prone to that than fixed income. But we like to believe – and we hope we are right – that EM can sort of stand on its own. It’s not going to necessarily derail the global growth picture.”

Emerging markets’ sensitivity to policy mistakes has decreased over the last four years and their FX evaluations have also improved, said Alejo Czerwonko, director of EM investment strategy at UBS Wealth Management.

Even if we do see that policy mistake, the reaction of EM will be milder
Alejo Czerwonko, UBS Wealth Management

“Even if we do see that policy mistake, the reaction of EM will be milder. Of course, EM will never be immune to Fed or [European Central Bank] policy mistakes, but if it does occur, we should see milder consequences,” he added.

The Fed and Bank of Canada have begun raising interest rates, with the US central bank looking to reduce its balance sheet in late 2017.

What’s a policy mistake?

But what would a policy mistake look like? For Alessio de Longis, vice-president and portfolio manager at Oppenheimer Funds, an environment where the Fed proceeds with reducing its balance sheet and conducts more than one or two rate hikes fits the bill.  

“That would be a policy mistake, because I think over the next 12 months we are likely to see somewhat of another soft patch of global growth. At the moment we reckon the only major bloc of the world that still has some stamina in its growth momentum is Europe, but both the US and EM are starting to feel a little bit of fatigue,” he said. “Nothing concerning, but that would be the environment we would be setting ourselves for – excess tightening in an environment where global growth is already no longer accelerating.”

“The soft patch we are envisioning does not alter the growth differential picture, because what we are talking about is not the level of growth or the level of the growth differential, but rather the momentum – the change in growth,” de Longis added. “When you really look at the potential for appreciation, particularly in risky assets, whether it is DM or EM, you need that momentum; you need that change in growth. In an environment where your growth differential remains solidly positive, carry is king. And in that environment, that is exactly the proposition you want for your EM story. The valuation picture, especially for local debt and high-yielding EMFX is still very supportive, which basically creates a much more benevolent backdrop for you to stomach soft patches and policy mistakes.”

Winners and losers

Managers said Argentina, India, Indonesia and Mexico are among their favourite economies because they tend to perform relatively strongly in more difficult environments. Brazil also gets a few nods, despite its ongoing political scandals, because the country’s fundamentals have shifted and it has come out of a deep recession. Turkey and South Africa have become less attractive.

“None of them escaped their political saga stories, but they are diverging in terms of their fundamentals,” said UBS’s Czerwonko.

As for the US dollar, participants on a chief investment officers’ panel believe the greenback will weaken over the next three to five years, as renewed growth in other economies weakens its appreciation.

“I think there are a lot of challenges for the dollar to sustain that [strength], especially as other economies are behind the US in terms of this cycle, and you will see renewed growth there,” said Holly Huffman MacDonald, chief investment strategist at Bessemer Trust.

Others argued the tipping point for the dollar might be closer, with an average 40% drop coming soon, with a potential 65% increase in the euro to follow as a result.

“If we assume that happens, it will have massive implications for all asset prices. This is probably the most important price to watch in the world today,” said Ulf Lindahl, chief executive and chief investment officer at AG Bisset Associates.

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